[House Hearing, 106 Congress] [From the U.S. Government Publishing Office] DECIMAL CONVERSION 2000: ARE THE MARKETS READY? ======================================================================= HEARING before the SUBCOMMITTEE ON FINANCE AND HAZARDOUS MATERIALS of the COMMITTEE ON COMMERCE HOUSE OF REPRESENTATIVES ONE HUNDRED SIXTH CONGRESS SECOND SESSION __________ MARCH 1, 2000 __________ Serial No. 106-113 __________ Printed for the use of the Committee on Commerce U.S. GOVERNMENT PRINTING OFFICE 62-974 CC WASHINGTON : 2000 COMMITTEE ON COMMERCE TOM BLILEY, Virginia, Chairman W.J. ``BILLY'' TAUZIN, Louisiana JOHN D. DINGELL, Michigan MICHAEL G. OXLEY, Ohio HENRY A. WAXMAN, California MICHAEL BILIRAKIS, Florida EDWARD J. MARKEY, Massachusetts JOE BARTON, Texas RALPH M. HALL, Texas FRED UPTON, Michigan RICK BOUCHER, Virginia CLIFF STEARNS, Florida EDOLPHUS TOWNS, New York PAUL E. GILLMOR, Ohio FRANK PALLONE, Jr., New Jersey Vice Chairman SHERROD BROWN, Ohio JAMES C. GREENWOOD, Pennsylvania BART GORDON, Tennessee CHRISTOPHER COX, California PETER DEUTSCH, Florida NATHAN DEAL, Georgia BOBBY L. RUSH, Illinois STEVE LARGENT, Oklahoma ANNA G. ESHOO, California RICHARD BURR, North Carolina RON KLINK, Pennsylvania BRIAN P. BILBRAY, California BART STUPAK, Michigan ED WHITFIELD, Kentucky ELIOT L. ENGEL, New York GREG GANSKE, Iowa TOM SAWYER, Ohio CHARLIE NORWOOD, Georgia ALBERT R. WYNN, Maryland TOM A. COBURN, Oklahoma GENE GREEN, Texas RICK LAZIO, New York KAREN McCARTHY, Missouri BARBARA CUBIN, Wyoming TED STRICKLAND, Ohio JAMES E. ROGAN, California DIANA DeGETTE, Colorado JOHN SHIMKUS, Illinois THOMAS M. BARRETT, Wisconsin HEATHER WILSON, New Mexico BILL LUTHER, Minnesota JOHN B. SHADEGG, Arizona LOIS CAPPS, California CHARLES W. ``CHIP'' PICKERING, Mississippi VITO FOSSELLA, New York ROY BLUNT, Missouri ED BRYANT, Tennessee ROBERT L. EHRLICH, Jr., Maryland James E. Derderian, Chief of Staff James D. Barnette, General Counsel Reid P.F. Stuntz, Minority Staff Director and Chief Counsel ______ Subcommittee on Finance and Hazardous Materials MICHAEL G. OXLEY, Ohio, Chairman W.J. ``BILLY'' TAUZIN, Louisiana EDOLPHUS TOWNS, New York Vice Chairman PETER DEUTSCH, Florida PAUL E. GILLMOR, Ohio BART STUPAK, Michigan JAMES C. GREENWOOD, Pennsylvania ELIOT L. ENGEL, New York CHRISTOPHER COX, California DIANA DeGETTE, Colorado STEVE LARGENT, Oklahoma THOMAS M. BARRETT, Wisconsin BRIAN P. BILBRAY, California BILL LUTHER, Minnesota GREG GANSKE, Iowa LOIS CAPPS, California RICK LAZIO, New York EDWARD J. MARKEY, Massachusetts JOHN SHIMKUS, Illinois RALPH M. HALL, Texas HEATHER WILSON, New Mexico FRANK PALLONE, Jr., New Jersey JOHN B. SHADEGG, Arizona BOBBY L. RUSH, Illinois VITO FOSSELLA, New York JOHN D. DINGELL, Michigan, ROY BLUNT, Missouri (Ex Officio) ROBERT L. EHRLICH, Jr., Maryland TOM BLILEY, Virginia, (Ex Officio) (ii) C O N T E N T S __________ Page Testimony of: D'Agostino, Davi M., Acting Associate Director for Financial Institutions and Markets Issues, General Government Division; accompanied by Cody J. Goebel, Associate Director for Financial Institutions and Markets Issues; and Jean- Paul Reveyoso, Senior Evaluator for Financial Institutions and Markets Issues, General Accounting Office.............. 4 Material submitted for the record by: Berkeley, Alfred R., letter dated March 31, 2000, to Hon. John D. Dingell, enclosing response for the record......... 65 Brodsky, William J., letter dated March 30, 2000, to Hon. John D. Dingell, enclosing response for the record......... 80 DeFoe, Philip D., letter dated April 10, 2000, to Hon. John D. Dingell, enclosing response for the record.............. 84 Dingell, Hon. John D., a Representative in Congress from the State of Michigan: Letter dated March 2, 2000, to Hon. Michael G. Oxley..... 59 Letter dated March 2, 2000, to Alfred R. Berkeley, requesting response for the record..................... 60 Letter dated March 2, 2000, to William J. Brodsky, requesting response for the record..................... 62 Letter dated March 2, 2000, to Philip D. DeFoe, requesting response for the record..................... 62 Letter dated March 2, 2000, to Meyer S. Frucher, requesting response for the record..................... 62 Letter dated March 2, 2000, to Salvatore F. Sodano, requesting response for the record..................... 62 Letter dated March 2, 2000, to David Krell, requesting response for the record................................ 62 Krell, David, letter dated March 30, 2000, to Hon. John D. Dingell, enclosing response for the record................. 96 Sodano, Salvatore F., letter dated March 31, 2000, to Hon. John D. Dingell, enclosing response for the record......... 91 (iii) DECIMAL CONVERSION 2000: ARE THE MARKETS READY? ---------- WEDNESDAY, MARCH 1, 2000 House of Representatives, Committee on Commerce, Subcommittee on Finance and Hazardous Materials, Washington, DC. The subcommittee met, pursuant to notice at 10 a.m., in room 2322, Rayburn House Office Building, Hon. Michael G. Oxley (chairman) presiding. Members present: Representatives Oxley, Shimkus, Wilson, Fossella, Ehrlich, Towns, Engel, Luther, Capps, and Markey. Staff present: David Cavicke, majority counsel; Linda Dallas Rich, majority counsel; Brian McCullough, majority professional staff; Robert Simison, legislative clerk; Consuela Washington, minority counsel. Mr. Oxley. The subcommittee will come to order. The Chair will recognize himself for an opening statement. Three years ago this committee led the effort to get the securities markets to convert from fractions to decimals. It was an important change. I wanted to do this for three reasons. One, I believe the free market, not the Government should determine stock prices; two, decimals would make the markets more accessible because they are easier to understand than fractions; and, three, decimals would promote the competitiveness of the U.S. stock markets because the rest of the world is already trading in decimals. After we reported legislation the exchanges agreed that they would convert to decimals. We agreed to let the markets convert after their Y2K efforts. Now that the Y2K computer crunch has come and gone, mercifully, we thought it a good time to see how the markets are doing on decimal conversion. Based on my recent visit to New York with our colleague Vito Fossella, and my review of the GAO testimony, the answer is, we're in pretty good shape. The markets are on schedule to convert this July. Initially there will be a spread of a nickel for most stocks. After we have had decimal trading for about 6 months, we anticipate that there will be no mandated minimum increment and we will have full free market pricing in decimals. I understand that some firms in the options exchanges may experience some difficulties because of increased trading and message traffic that decimals will bring. We are phasing in decimals by providing for the nickel increments in an attempt to alleviate those problems. Additionally, I'm open to other solutions that will help the options exchanges to get through this transition. Decimals was a good bipartisan achievement of which we can all be proud. I appreciate the work that the GAO has done, in monitoring decimal conversion for us and look forward to the GAO's testimony. And with that the Chair yields back and is now pleased to recognize the ranking member, the gentleman from New York, Mr. Towns. Mr. Towns. Thank you very much, Mr. Chairman. In the 105th Congress you proposed a bill that was so simple it was monumental. Your bill H.R. 1053 required our markets to join the rest of the world and price stocks in decimals rather than in fractions. After our passing the bill out of subcommittee, the market participants agreed that it was time to enter the 21st Century by converting to decimals. Now we are on the verge of reaching our goal; the markets were able to successfully navigate Y2K and they are now poised to conquer the next important task, converting from fractions to dollars and cents. While I'm anxious to see decimal conversion, I am a little concerned about some details. Fortunately my concern arises from one of the benefits that will occur in the market once it converts from fractions. Due to the increase of ``traffic'' that is bound to occur with decimalization, I'm concerned about whether or not there is enough capacity in our trading system to handle the new flow of information being created by shrinking bid and offer quotes. It is vital to ensure that our system has the ability to handle this conversion. I hope that the testimony from the General Accounting Office will be able to alleviate any concerns that I have in this area. I would like to applaud the industry who have worked to ensure that our capital markets will be ready to trade in decimals by July. Their steadfast commitment on this issue will help solidify that our markets remain the envy of the world and easier for every American to understand. I would also like to congratulate you, Mr. Chairman, for your leadership on this issue. It's been a very important victory for American investors in our Nation's capital markets. I thank the GAO for their testimony today and look forward to hearing just how ready our markets are for decimal conversion. Thank you very much, Mr. Chairman, again for having this hearing, and I yield back. Mr. Oxley. Thank you. [Additional statements submitted for the record follow:] Prepared Statement of Hon. Tom Bliley, Chairman, Committee on Commerce During the 105th Congress, Finance and Hazardous Materials Subcommittee Chairman Mike Oxley proposed a very good idea--H.R. 1053, the Common Cents Stock Pricing Act of 1997. His bill would have required our nation's exchanges to price stock in dollars and cents, rather than in government set fractions. I was an original co-sponsor of H.R. 1053. I agree with Chairman Oxley that pricing stocks in decimals will benefit American investors and our capital markets. Listing stock in decimals will make the ticker on the bottom of CNBC easier to understand for every American. It will also make our markets more competitive by allowing the market to determine the buy and sell price, rather than a government mandated spread. Today I am pleased to see that decimal pricing is just around the corner. The Securities and Exchange Commission and the industry have worked together to ensure that our capital markets will be trading stocks in decimals, rather than fractions, by July of this year. We are here today to hear from the General Accounting Office about the progress that has been made towards this goal. I congratulate Chairman Oxley, and Telecommunications, Trade, and Consumer Protection Ranking Member Ed Markey for their hard work which has led to an important victory for American investors and all participants in our nation's capital markets. I also thank the GAO for their review of the industry preparedness, and look forward to their testimony today. ______ Prepared Statement of Hon. Edward J. Markey, a Representative in Congress from the State of Massachusetts Thank you, Mr. Chairman. I would like to begin by commending you for calling today's hearing and for your persistent leadership over the last two years in pushing our nation's stock markets to move away from trading in fractions and towards trading in dollars and cents. This is an important pro-consumer initiative that will make our markets more efficient and competitive and save investors billions of dollars in lower trading costs. Three years ago this month, I joined with you, with Chairman Bliley, and several other Members of the Committee in introducing H.R. 1053, the ``Common Cents Stock Pricing Act of 1997.'' We introduced this legislation to correct an absurd anomaly in our nation's stock and options markets. More than two centuries after traders meet under the Buttonwood tree in lower Manhattan to form the New York Stock Exchange, stocks were still trading in increments of an eighth of a dollar--or 12\1/2\ cents. Some financial historians attribute this arcane practice to the time when the Spanish dollar was a widely used currency in America. These Spanish dollars routinely were cut up into ``bits'' or ``pieces of eight.'' Others suggest that the eighth could also be derived from the old ``New York dollar,'' a regional currency used during the early years of the Republic. Regardless of its origin, 200 years later, the rest of the America had long since moved on to buying and selling goods and services using dollars and cents. Clearly, it was time for the securities industry to catch up. Despite the protests of some in the industry that the issue was too complex, that we needed more hearings, that we'd destroy the profitability of the brokerage industry, this Subcommittee moved forward to approve our bill and direct the SEC to mandate a move to decimal pricing. And once we acted, the markets responded. The New York Stock Exchange, the NASDAQ, and the regional exchanges announced that they would immediately move from eighths to 16ths in preparation for a move to decimals in the summer of 2000. In response to this welcome and forward looking change of heart on the part of the securities industry, we decided to withhold further action on H.R. 1057 and closely monitor industry progress towards meeting the goal. As part of the Subcommittee's ongoing oversight efforts, I joined with you and Chairman Bliley last year to ask the General Accounting Office to monitor what actions were being undertaken by the SEC, the exchanges, and Wall Street securities firms to make decimal pricing a reality. Today, we will be hearing from GAO on their findings and recommendations. The good news is that progress is being made. The bad news is that a number of challenges still remain and some in the industry may be dragging their feet. We will hear that the primary challenge is the systems capacity of the computers and telecommunications systems used to transact trading, and that these challenges are particularly acute for the options exchanges. We will also hear that concerns about antitrust issues may have delayed efforts to develop market standards and exchange rules relating to decimal trading. Based on my review of GAO's testimony, I am convinced that it is possible for the industry to meet the deadlines for an orderly transition to decimals--if the industry has the willpower to do so. The SEC needs to be vigilant in pressing all market participants forward to decimals, and be willing to let market forces--rather than artificial exchange rules--set the minimum price increment for stocks. I continue to hear disturbing rumors that some in the industry might want to delay the move to decimals, or permanently lock in a nickel trading increment for stocks. This concerns me. The industry has now had three years to get ready. It's time for industry to do their bit, get off the dime, and give stock investors the opportunity to profit from spreads that range down to a penny. Thanks again, Mr. Chairman, for calling today's hearing. I look forward to hearing the testimony. Mr. Oxley. If there are no further openings statements then let me turn now to our distinguished witness, she is Ms. Davi M. D'Agostino, Acting Associate Director for Financial Institutions and Markets issues with GAO in the General Government Division. Ms. D'Agostino thank you for being with us today. And if you will, would you identify and introduce your cohorts here at the table. Ms. D'Agostino. Yes, I'd be happy to. And thank you for inviting us. This is Mr. Jean-Paul Reveyoso, Mr. Cody Goebel, and Mr. Keith Rhodes, our chief scientist. Mr. Oxley. Thank you. And you may proceed. STATEMENT OF DAVI M. D'AGOSTINO, ACTING ASSOCIATE DIRECTOR FOR FINANCIAL INSTITUTIONS AND MARKETS ISSUES, GENERAL GOVERNMENT DIVISION; ACCOMPANIED BY CODY J. GOEBEL, ASSOCIATE DIRECTOR FOR FINANCIAL INSTITUTIONS AND MARKETS ISSUES; AND JEAN-PAUL REVEYOSO, SENIOR EVALUATOR FOR FINANCIAL INSTITUTIONS AND MARKETS ISSUES, GENERAL ACCOUNTING OFFICE Ms. D'Agostino. Okay. Good morning, everyone. You asked us here this morning to discuss GAO's observations on the securities industry's progress toward implementing decimal trading. As you know, GAO has bee monitoring this issue at your request and testified on the actions needed to convert to decimals nearly 2 years ago. May I submit my full statement for the record and summarize my remarks. Mr. Oxley. Without objection. Ms. D'Agostino. Okay. Thank you. I'm going to focus my remarks today on three key areas. First I will discuss the progress made to date for converting to decimals. Second, I'll highlight some of the challenges that lie ahead for the U.S. securities industry to successfully trade at decimal prices. And third, I'll briefly cover some of the areas where we plan to focus our future efforts at your request and monitoring the industry. In 1998 testimony before this subcommittee GAO recommended that the Chairman of Securities and Exchange Commission or the SEC ensure decimal pricing got implemented in a timely manner after the industry prepared for the year 2000 date change. Most importantly, we recommended that SEC ensure that the industry establish definitive timeframes for implementing decimal trading and assess the impact of decimal trading on the industry's processing and communication systems capacities. SEC and the industry have taken actions to ensure that the markets begin decimal pricing in 2000. SEC has monitored the industry efforts coordinated by the Securities Industry Association, the SIA, to develop a plan, a schedule and standards for decimal pricing. SEC also issued two orders directing the industry participants to work jointly on these tasks. Importantly, SEC's most recent order issued on January 28, directs the stock and options and exchanges and the NASD to coordinate on a plan to begin decimal trading, as you said, by July 3, 2000. Also very importantly, SIA did commission a study of decimals impact on trading and quotation volumes. And the industry has now scheduled three industry-wide tests of decimal trading in April, May and June of this year. Details of the industry's plan are in a state of flux right now and things may change, but the illustration on your left shows some of the more detailed recent thinking on the phase schedule for implementing decimals. The industry plans a first phase to start in July 2000 as called for in the SEC order. And during that first month a small number of stocks, about 30, as discussed earlier this month at the SIA will be switched from fractions to decimal pricing in no greater than nickel increments. A second phase would then begin in which all stocks would be switched to decimals. At the same time the industry would pilot some number of stocks to be traded in penny increments. After January 2001, the final phase would begin in which individual markets would seek SEC approval for the specific increments in which they intend to quote their decimal prices. This phase is expected to end March 3, 2001. While these SEC and securities industry efforts and activities represent progress in preparing for trading in decimals, some key challenges in our view remain ahead for success. Possibly one of the most serious challenges facing the industry is the systems capacity demands that Mr. Towns mentioned of decimal trading and quoting as projected by an industry study. A private firm, SRI Consulting, did this study for the industry and its most recently updated projections show substantial increases in message traffic can be expected. The most striking increases in message traffic in a decimal/penny trading environment are projected in the options markets and the Nasdaq. The illustration board on your right shows the SRI projection that the options peak message traffic could increase over 3,000 percent from December 1998 levels by December 2001 if trading is in penny increments. They also projected that Nasdaq's peak message traffic could increase by 700 percent in the same period if trading is in pennies. It's important to note that SRI's projections take into account much more than just switching to decimal pricing. They also take into account recent record volumes in trading and increased competition among the options exchanges. Now, both the Options Price Reporting Authority or the OPRA and the Nasdaq are already having difficulty meeting message traffic demands with current capacity. OPRA plans to increase its capacity by the end of the year 2000, but that increased capacity will still be less than one- third of what SRI projects as needed to quote in penny minimum price variations, MPV. Even if OPRA could meet the needed capacity, the price changes would occur so quickly that human traders watching the computer screens might not be able to keep up. As a result OPRA is also taking steps to reduce quotation message traffic such as setting internal priorities on its own quote and trade reports. Other proposals are to discontinue price quotes for options with low trading volumes and establish minimum increments of five or ten cents for options quotations. In any case, because of potential market implications of these steps the SEC will have to review the proposals and approve any needed changes to rules. The Nasdaq has told SEC that they would not be ready to fully deal with their own lower projections of message traffic volumes until the first quarter of 2001. Under its current plans, Nasdaq will not be prepared to deal with message traffic volumes projected by SRI. In addition, because of capacity issues and readiness issues, Nasdaq will not be able to participate in the first two tests scheduled for April and May this year, and instead they plan to join the June 2000 test. Beyond the critical capacity challenge, industry participants need to work closely together in several areas to successfully convert to decimal trading in a timely manner. For example, industry must cooperate to finalize standards for market operations and practices. However, cooperation and progress in developing market standards has been hampered by antitrust concerns. Despite SEC and Justice Department efforts to mitigate these concerns, industry meetings on decimal- related market standards were not proceeding because of an ongoing antitrust investigation of the options markets and pending lawsuits. However, the January 28 SEC order, that I mentioned earlier, clearly states that industry cooperation in discussing developing and implementing decimal trading is imperative and in the public interest. And this order is expected to remove any further industry unwillingness to cooperate on decimals because of antitrust concerns. Other challenges remaining for the industry include assessing and proposing revised exchange and market rules as may be needed to accommodate decimal trading and readying the systems of the exchanges, broker-dealers, the vendors, and others for decimal prices. SEC has been encouraging the industry to address the needed rule changes and has been also examining the readiness of various firms' systems for dealing with decimals. Now, as part of our continuing efforts to monitor the industry's progress at your request, we plan to stay on top of a number of different aspects of their efforts. We want to continue to focus on the approval process for market rule changes, the regulators' readiness assessments of broker-dealer systems to handle decimals, and the results of the tests conducted among the exchanges and the member firms. In addition, we want to look at what the various industry committees are doing on market standards and implementation procedures. Mr. Chairman and members of the subcommittee that concludes my summary and we would be happy the answer any questions you have at this time. [The prepared statement of Davi M. D'Agostino follows:] [GRAPHIC] [TIFF OMITTED]66566.001 [GRAPHIC] [TIFF OMITTED]66566.002 [GRAPHIC] [TIFF OMITTED]66566.003 [GRAPHIC] [TIFF OMITTED]66566.004 [GRAPHIC] [TIFF OMITTED]66566.005 [GRAPHIC] [TIFF OMITTED]66566.006 [GRAPHIC] [TIFF OMITTED]66566.007 [GRAPHIC] [TIFF OMITTED]66566.008 [GRAPHIC] [TIFF OMITTED]66566.009 Mr. Oxley. Thank you very much, Ms. D'Agostino and the Chair would recognize himself for 5 minutes for questions. Addressing the challenges that you pointed out, I take it that the clearly overriding challenge is on the capacity issue; is that correct? Ms. D'Agostino. That's our assessment, yes. That seems to be the most difficult challenge ahead, I think. Mr. Oxley. Now, there have been some, including myself, that have tried to draw a similarity between the conversion to Y2K and conversion to decimals. And I know the GAO had been involved--maybe not you personally, but obviously in that issue. Are there some parallels here, are some of the fears that were there with Y2K that proved not to be the case also perhaps the same kind of fears that are addressed with the conversion to decimals? Ms. D'Agostino. I think it's a little bit of a different problem because it mixes the actual physical change to decimal pricing which isn't all that difficult a problem with the record volumes that the industry is experiencing even without decimals and that compounded with the expected increases in trading from moving to decimals as the spreads narrow. So its capacity. Mr. Oxley. Now the demonstration you have in front of us here indicating the phases of converting to decimals, this is the industry draft as opposed to what the SEC had proposed; is that correct? Ms. D'Agostino. It's actually right in alignment with what the SEC order lays out. The question is, what happens in the middle there? The beginning date is the same, and I think the end date is the same, the question is, how long it takes to actually convert, how long the pilot is, and the increments at which each of the markets and which stocks would trade. And I think the order gives the industry that wiggle room in the middle to do what it thinks is prudent. Mr. Oxley. And as I understand it from the SEC, based on a meeting we had with Mr. Fossella last week, in New York, that the SEC is also still seeking comment and suggestions that they appear to be flexible in trying to make this work to everybody's satisfaction to get to the goal, but to get to the goal the right way. The capacity issue even if we didn't have decimals would be, according to your testimony, a problem anyway; is that correct? Ms. D'Agostino. Right now, yes, that's true, Mr. Chairman. Mr. Oxley. And is this a--aside from what's going on out there, is this basically a technological problem? The capacity issue in and of itself appears to be a challenge technically; is that correct? Ms. D'Agostino. Yes, it is. In fact, Mr. Rhodes, would you like to respond to that? Mr. Oxley. Would you identify yourself, again, for the record, please? Mr. Rhodes. My name is Keith Rhodes and I'm the Chief Scientist of the General Accounting Office. And, yes, it is, it's a technical issue in that if you look at how the message traffic is being moved, what you are trying to do is take a ten-inch fire hose and hook it up to a soda straw. And what you have to do is make certain that the soda straw is as large as the ten-inch fire hose. And whether the stock market or whether the markets in general go to decimals, as we've seen, there are already capacity problems that exist and these will just be compounded. But it is purely a technology problem. Mr. Oxley. Ms. D'Agostino, could you give us an idea as to who you talk to, market participants and the like, not specifically individuals, but I mean, in your study who did you talk to and was in fact the capacity issue the No. 1 concern at least in the markets? Ms. D'Agostino. The team has basically attended or sat in on otherwise telephonically every single SIA meeting that's occurred on this matter, and has also been in contact with the exchanges and Nasdaq. They've gotten some information from Nasdaq that indicates and actually even raised our concerns about the capacity issue to some extent very recently. The options markets have raised this concern in OPRA to us, I mean, in front of us and it's been an issue all along the way in the discussions at SIA. Mr. Oxley. Thank you. My time has expired, let me now recognize the ranking member, the gentleman from New York. Mr. Towns. Thank you very much, Mr. Chairman. Your testimony indicates that the OPRA system for disseminating options trade and price quote messages has a current capacity of 3,000 messages per second. And that OPRA officials intend to increase the capacity to 12,000 messages per second by the end of the year. Ms. D'Agostino. Right. Mr. Towns. Your testimony goes on to say, ``however, this additional capacity will not be adequate to accommodate the SRI projections'' for quotation traffic. The options markets have been taking a number of steps and propose to take a number of steps to reduce traffic, but they also are not enough and will have an adverse effect on the transparency of our options market. I am concerned that we have a problem--well, a disaster, actually, in the making. What does GAO recommend that SEC and the options markets can do to head off this serious problem as I see it? Ms. D'Agostino. Well, Mr. Towns, we actually just received a copy of the proposal that OPRA submitted to the SEC. I think SEC is just starting to take a look at it themselves. This proposal lays out a whole number of options of opportunities or ideas to reduce the message traffic volume. Some of these ideas are ideas that are clearly not going to have a bad impact on transparency. For example, if they delist inactive options, that's not going to hurt transparency. Some of the other ones, however, might cause concern about transparency and that's why SEC, I think is going to take a really hard look at each one of the strategies that OPRA has proposed and consider it in terms of what might be needed in terms of rule changes down the road if they do approve the strategy. Mr. Towns. Mr. Chairman, I would like to request that GAO submit that for the record. Mr. Oxley. Without objection. Mr. Towns. Thank you very much. [The information referred to follows:] [GRAPHIC] [TIFF OMITTED]66566.010 [GRAPHIC] [TIFF OMITTED]66566.011 [GRAPHIC] [TIFF OMITTED]66566.012 [GRAPHIC] [TIFF OMITTED]66566.013 [GRAPHIC] [TIFF OMITTED]66566.014 [GRAPHIC] [TIFF OMITTED]66566.015 [GRAPHIC] [TIFF OMITTED]66566.016 [GRAPHIC] [TIFF OMITTED]66566.017 [GRAPHIC] [TIFF OMITTED]66566.018 [GRAPHIC] [TIFF OMITTED]66566.019 [GRAPHIC] [TIFF OMITTED]66566.020 [GRAPHIC] [TIFF OMITTED]66566.021 [GRAPHIC] [TIFF OMITTED]66566.022 [GRAPHIC] [TIFF OMITTED]66566.023 [GRAPHIC] [TIFF OMITTED]66566.024 [GRAPHIC] [TIFF OMITTED]66566.025 [GRAPHIC] [TIFF OMITTED]66566.026 [GRAPHIC] [TIFF OMITTED]66566.027 [GRAPHIC] [TIFF OMITTED]66566.028 [GRAPHIC] [TIFF OMITTED]66566.029 [GRAPHIC] [TIFF OMITTED]66566.030 [GRAPHIC] [TIFF OMITTED]66566.031 [GRAPHIC] [TIFF OMITTED]66566.032 [GRAPHIC] [TIFF OMITTED]66566.033 [GRAPHIC] [TIFF OMITTED]66566.034 [GRAPHIC] [TIFF OMITTED]66566.035 [GRAPHIC] [TIFF OMITTED]66566.036 [GRAPHIC] [TIFF OMITTED]66566.037 [GRAPHIC] [TIFF OMITTED]66566.038 [GRAPHIC] [TIFF OMITTED]66566.039 [GRAPHIC] [TIFF OMITTED]66566.040 [GRAPHIC] [TIFF OMITTED]66566.041 Mr. Towns. Is there a commercially available system that can handle the options volume anticipated under decimal trading? Ms. D'Agostino. Keith? Mr. Rhodes. The standard systems that are being used, yes, it's not a matter of a system has to be invented to handle this. It's a matter of taking existing systems, and in the discussions that we've had, it's a matter of adding additional processors and additional computer systems in place and additional capacity in terms of communications, new switches and things like that. Nothing has to be invented to make this increased capacity. It's a matter of something has to be bought, has to be put i place, and it has to be tested. So there's no--it's not that you can go to an off-the-shelf system that says, here's a computer that will handle 32,000 options of 32,000 messages per second for options traffic at its ultimate peak, it's a matter of going in and taking several computers or several processors and putting them together and getting multiples of faster switched in place. So there's nothing that has to be invented to solve this problem, it's a matter of taking existing technology and putting it in place. Mr. Towns. So we have to be careful about these timetables? Mr. Rhodes. Yes, we do. Mr. Towns. As you know, the SEC recently approved the application of the International Stock Exchange to operate as the first electronic options exchange. Does the SRI study include its volume projections? Would its operation further raise capacity concerns or not? Mr. Rhodes. I don't believe that the SRI numbers that we include in our testimony include the ISC projections. But the numbers that OPRA has been working with that are very similar to the same level that SRI is projecting do include the impact of the ISC with an additional buffer that they always try to build in to have some excess capacity. But from what we could see, the numbers were very comparable. Mr. Towns. Do you want to add something to that? No. All right. Let me thank you very much, Mr. Chairman. I think that it's important that we continue this dialog because I have some reservations, I must admit, you know, in fact, I guess a better term, I'm a little nervous about it because there's still a lot of uncertainties. And I think that we need to be able to come up with some answers to some of these questions. And on that note I yield back. Mr. Oxley. The gentleman yields back. Let me inform the ranking member that this is a first of probably a series of hearings that we'll have on this important issue. We wanted to set the stage with the GAO report and we appreciate their testimony and the information that they're giving the committee. This is of utmost importance for the markets and we want to make certain that everything works smoothly. And this is, again, the first step in that effort. Mr. Towns. That calms me a little. That calms me down a little bit. Thank you, Mr. Chairman. Mr. Oxley. And the gentle lady from Mexico. Ms. Wilson. Thank you, Mr. Chairman. I'm glad that the ranking member is feeling comfortable. Mr. Oxley. He's chilling. Ms. Wilson. Mr. Chairman, I really just had a number of kind of initial questions, and I have met with some of the folks who are running the markets and I'm very glad to see this change to decimals. I don't 6/18ths or 6/56ths and those kinds of things and I was interested to see your projected increases in volume. I understand that there's also some research going on, and I don't know if you're familiar with it, but it's really kind of chaos theory research that has less to do with volume than it does with change of behavior. And I see Mr. Rhodes nodding his head, and I wonder if you could talk a little bit about what some of that modeling is telling us about how behavior might change in the stock market--and it's less relevant or probably less significant when they go to dimes or nickels, but there's some interesting questions about when they go to pennies. And I wonder if you could share what you know? Mr. Rhodes. If you're referring to the work out of the Santa Fe Institute? Right. The idea is that you would take the spread and you establish what are called ``strange attractors'' inside the structure of message traffic and show that there are two directions that the volume can go. One is that you have tremendous peaks, and then there are also views that the market volume will actually rise higher or the volume--the domestic traffic volume will rise higher than even the SRI projections. So the concern there is that if you follow not just historical data and not just estimates on the load, but you look at how people operate and decisions that people make and the kinds of decisions that they collect to, then you get this--you get these series of spikes and it's not that overall you have 32,000 messages per second, it's that at any given point in time you can have hundreds of thousands of messages at a peak and 32,000 becomes sort of a gradual curve. And, in a way, that follows some of the discussion that we heard with the broker dealers because there were discussions about, well, you know, nobody will trade at a nickel. You know, everything will stay at a nickel and no one will go lower. And then there were other traders who said, a nickel won't last till lunchtime. So from the Santa Fe perspective, they're figuring out how honest and true and reliable a nickel would be versus a penny. And some of their theories are that it will go to pennies immediately. And, therefore, the volume would rise tremendously immediately. Ms. Wilson. Is it a question of just volume or does behavior change too? I mean, for example, how does that affect--I don't know if I've got the right question or not---- Mr. Goebel. One of the things that the SRI study did when it was estimating what the impact of nickels was, they could draw on historical data because we've had experience in the U.S. markets with the move from 8ths to 16ths, but the move from there down to pennies was basically unprecedented for our markets and literally for markets around the world even in other exchanges. Overseas they trade usually in higher increments than pennies. So what they did to try to estimate how behavior--trading behavior would change was they went to all of the range of various market participants--dealers, upstairs traders, mutual fund, trading desk managers, that kind of thing--to try to find out what those people would do in a penny environment. And in general the expectation is that whereas in the current environment where someone may offer, say, 5,000 shares to trade at a nickel, now if there's more price points, they might offer a thousand at a penny, 2,000 at three cents, so the volume that previously traded at one price might be spread over a number of price points. And that's what creates this additional quotation volume and additional trading. And that experience is borne out on the markets, for instance, Toronto. Ms. Wilson. Have they asked questions in these same kind of studies and groups in the different players about whether behavior is likely to change at a point of crisis or at a point of rapid change in the stock market, or is that just really a volume question? Mr. Goebel. Yeah, I don't believe the SRI study took into account analysis sort of market events occurring. And I think they--as a matter of fact, they even qualified that their day may not necessarily speak to what could occur in situations like that. Ms. Wilson. Okay. Thank you very much. Thank you, Mr. Chairman. Mr. Oxley. That time is expired. We turn to the gentle lady from California, Ms. Capps. Ms. Capps. Thank you, Mr. Chairman. I'm very pleased that you called this hearing today, because obviously this is a very important issue. And I appreciate the testimony that you have given, Ms. D'Agostino, and for your colleagues being here, as well updating us on the markets' conversion to decimals. Ensuring that our stock markets are able to handle a decimal conversion efficiently and smoothly is of great concern to all Americans, whether or not they realize it. Once done, of course, the goal is going to be terrific, saving consumers billions of dollars, increasing liquidity in the markets, encouraging investments. This is all to the good. I'm still--I share Mr. Towns' nervousness, I guess. I'm still concerned about the problems that you've pointed out and I appreciate that you've addressed with the previous questioner the studies themselves and the kind of confidence that GAO has in the estimates that have been given, really, by the industry itself. If I could bring up one other issue for your comment--the average daily trading volume on Nasdaq has increased 61 percent over the last year and that due to that Nasdaq is experiencing processing strains. How does this strain manifest itself? Is this something that is generally appreciated and perceived by the trading public? Mr. Goebel. Yeah, we didn't do a lot of research on exactly how those things were playing out for Nasdaq. From what we understand some of their internal systems may be experiencing queuing beyond those of the other systems, but they provided us with some information indicating what plans they intend to take to address the individual systems that as a group make up their entire sort of trading infrastructure. And in some cases it includes adding additional message switches and things like that to take those bottlenecks out of the various components. Ms. Capps. So they already have a system in place? For as the smaller parts of this come to their attention that they can pull into place? Mr. Goebel. From their response, they're attempting to increase capacities and processing capabilities in all the various parts, but as a whole, they still face a challenge in meeting some of the estimates that we discuss in our testimony---- Ms. Capps. I see. Mr. Goebel. [continuing] because trading volumes have been so high lately that they'll just continue to go up further. Ms. Capps. Does an investor perceive this, or what's their reaction, then--the public? Mr. Goebel. It's probably not something that investors are individually aware of unless they experience just slowness in getting an order executed. Ms. Capps. I see. Mr. Goebel. So it's sort of that behind-the-scenes effect. Ms. Capps. Okay. So it's being handled, at least to a degree that you feel somewhat comfortable with. Of course, this is the current status, not what we're anticipating? Mr. Goebel. Yes, I mean, I guess as Davi pointed out, we know they're taking steps, but there still remains a gap in meeting the kinds of projections that are expected to arise in the next couple of years. Ms. Capps. And then one sort of related issue which is troubling to me is the fact that Nasdaq will not be participating in the first two industry-wide tests, which are scheduled I believe for April and May, and that they haven't factored into their planning the increased estimates from SRI. Are you concerned about this and is one test run in June going to be enough for this huge issue with Nasdaq in your opinion? Ms. D'Agostino. That's a very good question. We haven't even thought about whether or not one test would be adequate. But we can say that actually the June test date was added for the Nasdaq because it wouldn't be able to make the two that were originally scheduled. And actually over the period of doing this work we were initially very highly concerned about the risk posed to the options, and now in recent weeks with what we've learned about Nasdaq's capacity and their plans, we're more concerned about the Nasdaq---- Ms. Capps. Well, what happened---- Ms. D'Agostino. [continuing] for the longer hall without taking some serious due diligence and action to enhance their capacity. Ms. Capps. Yes, well, have you developed scenarios for a response, say, should the test not be what you want to see in June? I mean, the results could be all over the map, right? Ms. D'Agostino. They could be. Mr. Goebel. It might be worth pointing out that the tests that the industry has designed, the three tests that Nasdaq will participate in the June one are essentially designed to test the processing changes, can they actually accurately trade in decimals, and they don't include a capacity element. So it's very expected that the processing changes that the exchanges and Nasdaq have made will likely work out. They're going to run scripted trades and things to make sure that the messages that are appropriate to send come back and forth. The testing of capacity will more or less come out of the pilot that they run during the second phase of implementation where they're going to take a selection of hopefully representative securities--stocks and options--and see how they actually trade, what kind of volumes are experienced in those securities during that pilot, and that will really give them some indication of the actual impact of decimals on capacities of systems. Ms. Capps. I guess I would say, I hope we can stay in touch with you on this issue. Mr. Oxley. They're our lifeline, we'll keep communication open. Ms. Capps. Thank you very much. Mr. Oxley. The gentle lady's time is expired. The gentleman from Illinois, Mr. Shimkus. Mr. Shimkus. Thank you, Mr. Chairman. Mr. Chairman, I would like to yield back my time and listen to the next question if someone else has one before I ask. Mr. Oxley. Okay. I owe you one. Mr. Shimkus. You owe me more than one. Mr. Oxley. The gentleman from New York, Mr. Engel. Mr. Engel. Thank you, Mr. Chairman. I too have a lot of trepidation about this. In fact, when the committee was first looking at this, I was cautioning and saying, why do we not let the market regulate itself. And then I said I thought I sounded too much like a republican. Mr. Oxley. Fat chance. Mr. Engel. Don't worry, Mr. Chairman, you were at the stock exchange that is week, but I was there a few hours after you, so I got the full report. We know that the timeframe is troubling. I wish you would just talk about that a little bit. The questions here have been--people have asked about the increase in trade and quotation traffic, there's a fear that the computer capability won't be able to cope with it. I thought we were rushing into this, can you just talk a little bit about what you've seen and your impressions of the computer capability and the timeframe and some of the fears that you mention in this report? Wouldn't we be better off to just kind of slow this down a little bit? Ms. D'Agostino. Well, I think that industry is putting together a plan that is very well thought out and involves phasing in to allow for time to the members who aren't ready to catch up. But it will require them to due diligence and upgrade the systems that need upgrading to meet the scheduled date. It's not clear that adding more months to the schedule is necessarily going to solve the capacity issue. What will solve the capacity issue is investing in capacity upgrades. Mr. Engel. Well, for instance, the question Ms. Capps asked about Nasdaq, you answered Nasdaq couldn't make the first two, so---- Ms. D'Agostino. Right. Mr. Engel. [continuing] really only having one, and you were unsure about whether or not that would be adequate. If we had more time and perhaps there could be more than one, wouldn't that just be better. Ms. D'Agostino. Yes, they certainly could schedule additional tests including capacity tests which was an idea that we sort of shared amongst ourselves, but didn't fully develop to be honest with you. Even during the phase-in period to March 2001. There are a lot of things that can be done concurrently during this schedule and since the participants seem to have differing states of readiness in terms of capacity, I mean, that's really incumbent on them to bring themselves up to speed for the schedule. Mr. Engel. Let me ask you this, a public/private partnership was created between the Securities Industry Association and the Securities and Exchange Commission to help implement the conversion to decimals. Can you comment on how that partnership has been functioning as we're moving toward implementation? Ms. D'Agostino. SEC has been monitoring and even maybe participating in a lot of the SIA--well, actually all of the SIA committee meetings. They've been helpful, like, for example, in the SRI study. They provided assistance in that regard. They've really been staying on top of this and I think working closely with all of the players to try to make sure the solutions that they come to are collaborative as opposed to directive from the SEC to the industry. Mr. Goebel. It's probably worth pointing out that the SRI gained a lot of experience from spearheading the year 2000 efforts for the industry because it was one of the things that definitely affected every participant in the securities markets and they established a committee structure and timeframes and testing schedules that obviously worked very well for Y2K. They've in essence transferred that sort of thinking and infrastructure to the decimals issue and it seems to have helped it move along as fast as it has. And SEC has been working and interacting with all these players throughout. So, it appears to be successful. Mr. Engel. If you see the testimony and some of the trepidation that some of us had in previous committee hearings it was the Y2K problem was foremost in our minds in terms of worrying about that, and on top of that worrying about decimalization. Obviously we still have a long way to go. I want to also thank the Chairman for these hearings and I look forward to continuing to ask these questions because, you know, again, we do have concerns. Obviously I represent New York and it's a very important industry to our City, and to our State and the country, and I just worry that we may be rushing too quickly into this. Mr. Towns. Would the gentleman yield? Mr. Engel. Yes, I would certainly yield. Mr. Towns. I would like to associate myself with that part of your question. Mr. Oxley. I would say to my good friends from New York, I think it's probably in the water up there that you're nervous about anything anyway. And we'll deal with that as time goes by. The gentleman from Maryland. Mr. Ehrlich. I apologize for the lateness--my lateness. I am particularly interested in cost conversion compared to investor savings, projections, numbers, I'm sure you all have talked about this, but for my edification, with apologies to room, could I hear a quick synopsis with respect to that issue? Ms. D'Agostino. Are you asking--I just want to clarify, are you asking what this effort is going to cost the industry---- Mr. Ehrlich. Yes. Ms. D'Agostino. [continuing] versus what the expected savings to investors? Mr. Ehrlich. Yes, ma'am. Ms. D'Agostino. Okay. Basically the only cost estimates we've seen is a final draft study by the Tower Group that was done for the SIA, and they estimate that decimals will cost the industry $907 million--I'm sorry, yes, million dollars. And it's a one-time cost. Mr. Ehrlich. Right. Ms. D'Agostino. Some of the studies that we've seen, and they have a range of estimates going from $300 million up to $2 plus billion and there are a lot of, you know, questions about some of those estimates. But in any case, these are annual savings expected to accrue to investors from moving to decimals. So it's a one-time sunk cost of $907 million against annual savings of anywhere from $300 million to $2 plus billion. Mr. Ehrlich. On the savings side, what accounts for the wild disparities in the numbers? Ms. D'Agostino. They include and exclude various factors. For example, some of the studies might not be accounting for the fact that a lot of trades aren't made on spreads and various other things. But that's basically---- Mr. Ehrlich. Thank you. I yield back, Mr. Chairman. Mr. Oxley. The gentleman yields back. The gentleman from Minnesota, Mr. Luther. Mr. Luther. Thank you, Mr. Chairman. Just one quick question. One of the areas where there's been some concern on behalf of consumers is this whole area of principal trades where underwriters are making markets themselves and the profits that are involved in that. How will this impact? What impact will this have in that area of principal trades? Mr. Goebel. In our previous testimony last year, we did speak with all the folks we tried to talk to about the impact on dealers and we also tried to look at what impact it had had on dealers and principal traders in the other markets. And I think what came out of that was that it was a mixed effect. As spreads decline, they may actually make less in trading profits, but there are generally more trades that occur and the data that was available at that time showed that it was a neutral impact on trading profits. For example, in Toronto, there was no change in the profits of the dealers. Some of the other work we did found that some market makers withdrew from making markets and securities for economic reasons, but Nasdaq reported to us after the moving sixteenths that reduced spread similarly, additional market makers entered the market and they saw no net effect as a result. So it seems to be a mixed unclear impact. Mr. Luther. Yield back. Mr. Oxley. The gentleman yields back. The Chair is now pleased to recognize one of the leaders in this effort and another nervous New Yorker, a gentleman from Staten Island. Mr. Fossella. I'm calm, Mr. Chairman. Thank you, Mr. Chairman, I'll be very brief. I know there's been a lot of attention on the options market and there seems to be a sort of geometric problem associated with the increase in the number, at least in capacity, but what about the equities markets, No. 1; to what degree is there a problem there? And second, there seems to be a level of concern with the current conversion to decimal trading, at least as the time tables allow the number of--do you have any other suggestions or solutions to address that concern that you've raised, and others here have raised? Ms. D'Agostino. I guess, let me start with the first part of your question. And how are the equities markets bearing or how do they look right now at this snapshot? Right now the New York Stock Exchange, for example, appears to be less of a risk toward successfully handling decimals trading by 2001 based on the SRI projections. But the Nasdaq, on the other hand, does not pose such a low risk. The updated estimates from the SRI projections have caused additional concern on the part of the Nasdaq based on our discussions just 2 days ago. So that's where we think we see some risk on being able to handle the capacity demands posed by this move. But, again, I think we also said earlier that they're having trouble processing their current demands without decimal trading. So, there are things that the Nasdaq are going to have to do to ready itself for decimals and also prepare itself for the increased volumes they're likely to experience in the coming months without decimals. Mr. Fossella. Thanks. But, if I may, there is a timetable set for the conversion to decimals. There seems to be a risk associated with that. I don't know to what degree you're posing there's a risk. Are there any--if you had your druthers at this point, what would you recommend with respect to the current conversion to decimals timetable? Ms. D'Agostino. We don't have any issues with the current timetable. To be honest with you, I think it was set jointly with the industry. I mean, the industry basically came up with this timetable. And to the extent that different market participants are at different states of readiness, I think that the schedule should suggest to the participants what they need to do in the coming months to ready themselves. Mr. Fossella. Is that possible? Can everybody step up to the plate in your estimate? In your opinion can everybody step up to the plate given the current timetable? Mr. Goebel. The timetable that we reflect in the chart is already a different timetable than just several months ago. Originally some of the later phases were going to start as soon as October for unrestricted trading in decimals. So there's already been an adjustment and some additional time added because of the developing capacity concerns particularly on the Nasdaq which is, you know, setting record volumes almost daily. The schedule also embodies various points where they're going to be assessing what's going on after the initial trading in nickels, the pilot for pennies will also provide data that will allow the SEC and the industry participants to formulate the plan for the next step, I think. And in January they're-- the SEC order directs the markets to either jointly submit a proposal for what the MPV should be for the market, or allow the individual exchanges to set that. But I'm sure they'll take that into account with what their capacities are at that point. Mr. Fossella. I'll conclude, Mr. Chairman, thank you. Mr. Oxley. The gentleman yields back. Mr. Shimkus. Mr. Chairman, if I may? Mr. Oxley. The gentleman from Illinois. Mr. Shimkus. Just briefly. I'm really excited about this. I think that the players who might be lagging behind had better catch up or they'll lose their business base. I am excited about these projections of increase, I'm excited about the smaller margin for the traders, and more involvement by the consumer. But I understand the concerns, we want the system to succeed and I can appreciate that. The only question I have is--and I apologize too, I was in a meeting up here. Mr. Rhodes' name is not on this witness list, can you tell me who are you representing and why are you at this table? Mr. Rhodes. I'm with the General Accounting Office. Mr. Shimkus. Okay. You're just---- Mr. Rhodes. I'm their chief scientist. Mr. Shimkus. Okay. Thank you very much. That's all I have, Mr. Chairman. Mr. Oxley. Thank you. And the gentleman yields back. Let me indicate to the members that this is an historic occasion in that the markets are going to decimals. We will now join the rest of the world in decimals, in large part because of what this committee was able to do, and we stand ready to work with the GAO and with the SEC and all interested parties to make certain that this transition, just like the transition in the Y2K is seamless and reasonably painless. I think the gentleman from Illinois pointed out some of the real benefits here of going to decimals. Obviously the markets at the end of the day will be able to handle this kind of capacity and it will be of good news for them because that's a lot of traffic and ultimately that's a lot of money. At the same time the consumer is going to benefit by the narrower spreads and by functionally illiterate people like myself who don't understand fractions to better understand the market and I think have more confidence in the marketplace as well. So at the end of the day working with the SEC, with GAO, and with everybody involved, I would say to my friends from New York, that this will be a very historic occasion and one I think we'll look back on with a great deal of pride in changing how these markets work. So we look forward to working with all of you and we will, as I indicated earlier, have another hearing, at least one other hearing as we move toward that July date of converting to decimals for the first time in our history. The Chair would ask unanimous consent that all members' opening statements be made part of the record, and so ordered. And with that, the committee stands adjourned. 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